Amid extreme stock-market volatility, investors often take extra measures to protect themselves. One popular strategy is to buy put options, which shield against a drop in share prices, thus driving up the cost of such options. But research recently published by Stanford GSB finance professor Hanno Lustig shows that financial index put options remained relatively cheap during the 2007-2009 economic crisis because investors were fairly confident that the government would bail out the banking sector rather than allow it to fail.

Lustig, with Bryan Kelly of the University of Chicago and Stijn Van Nieuwerburgh of New York University, examined the prices of put options on the financial sector during the most recent recession. Put options act as “crash insurance” by giving investors the right to sell shares at a predetermined price, which limits their losses when share prices fall. The researchers found that the price of put options covering the entire financial sector, or index options, remained relatively inexpensive compared with a basket of such options on individual financial firms. In particular, the spread between the index options and the basket was wide. Those findings run counter to textbook finance, which says that when share prices of firms in a given sector move up and down in unison, as they tend to do during a crisis, the index-basket spread should narrow.

Lustig says that during the crisis, index put options covering the entire financial sector were relatively inexpensive compared with baskets of put options because the federal government made investors believe it would protect the industry if it was in danger of failing. Investors appear to have taken the government’s various policies and public statements seriously enough to assume they didn’t need to buy index put options, thereby lowering demand for those options and driving down prices.

The promise of a bailout served as a kind of “free insurance” to investors with a total value of $282 billion.

Although the government never explicitly promised that it would keep the financial industry from collapsing, “we can paint a picture that suggests that investors had this model in mind,” says Lustig. “Investors were constantly trying to gauge the intent of government regulators, the Fed, and the Treasury, listening to figure out how much loss they were willing to bear in the financial sector. Investors were not deluding themselves but were being savvy and rational.”

In particular, the researchers found that the cost of a basket of individual-bank put options exceeded the cost of index options on the industry by 12.4 cents per dollar. By comparison, before the crisis, the spread between the basket and the index options never exceeded 3.3 cents per dollar. The relatively low prices of the index options show that the government was effectively boosting investor confidence in the entire financial industry and was “successful in convincing us” that it would protect the industry as a whole, says Lustig, even though it may be willing to let individual banks fail.

“Our evidence implies that the financial sector equity holders enjoyed a sizable government subsidy,” the researchers wrote. Government policy typically favors debt holders over equity investors during a crisis, but, Lustig, Kelly, and Van Nieuwerburgh estimate that the promise of a bailout during the most recent crash served as a kind of “free insurance” to investors with a total value of $282 billion.

At the same time, the relatively higher prices of put options on most individual financial firms suggest that investors believed that the government was willing to allow individual companies, especially smaller banks, to fail. People who were heavily invested in a single small firm, which may have benefited less from an industry bailout, may have believed that they needed to buy put options on that specific firm to protect themselves, thus putting upward pressure on the price of that company’s put options.

The researchers note that once investors become convinced that the government will protect an industry, then other actors, particularly executives within that industry, are also inclined to believe it. And that opens the possibility of moral hazard: Banks, for example, believing they have a government-sponsored safety net, may choose to take on risky endeavors, like underwriting shaky mortgages.

That possibility of distorting incentives is a reminder of potential unforeseen downsides to government intervention in markets, especially if it makes an activity appear less risky than it actually is. When governments intervene, “you’re distorting market prices and there’s always cost to doing that,” Lustig says. “If you lower the price of some types of risk, bank executives will have too much of it on the balance sheet.”